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Magical Secrets of Small-Cap Investing

A large-cap investor searches for some small-cap stock ideas.

I have to admit that I'm one of millions of people who like to make goals and plans for the next 365 days. Some of my resolutions are as simple as "call Mom more frequently," or "use the stairs, not the elevator," or my annual "finish War and Peace" pledge.

While these are all admirable ambitions, my most important goal is to find a few small-cap stocks where I can park some of my cash.

I'm basically a large-cap investor, and I have been most of my life. Please don't email me that I've missed some of the best years ever to be a small-cap investor. As I've watched my investment in Merck(NYSE:MRK)crumble, the S&P SmallCap 600 Index is up more than 1.7 times over the past five years.

It pains me to realize how much better my portfolio would look had I instead invested in a few Motley Fool Hidden Gems small-cap selections, which on average are trouncing the S&P 500 (they've gained 35% since the newsletter's inception, versus 11.5% for the S&P 500). Well, lesson learned.

Small caps, here I comeSo I now realize (finally) that I should invest at least a part of my portfolio in some small-cap stocks. Now what? Besides reading through some of the past Hidden Gems reports, I thought I would also use some knowledge I picked up after reading Joel Greenblatt's new book, The Little Book That Beats the Market.

Greenblatt has a long-term record for beating the market as founder and manager of New York-based Gotham Capital. I picked up a copy of his book after Bill Barker profiled it last fall. It's a quick read, so you, too, may want to buy a copy.

Greenblatt's primary investment theory is this: A portfolio consisting of companies generating high pre-tax returns on capital (between 75% to 100%), and selling at an "earnings yield" (operating profit divided by enterprise value) above 10% will produce superior investment returns over time. It makes sense to me, so I decided to apply his data to my research.

By visiting his companion website, MagicFormulaInvesting.com, an investor can generate a list of stocks currently meeting these criteria. With a specified $100 million market-cap minimum, Mr. Greenblatt's "magic formula" spits out a list of companies, which I then limited to 30 U.S.-traded stocks with market caps below $1 billon.

I then wanted to look only at those companies that have seen double-digit revenue growth for the past few years. Of these companies, I decided to focus on the following three.

FORE!!Of the three, I'm most intrigued by Aldila, the golf-club-shaft manufacturer (and not just because my driver could use some help).

The stock has almost doubled over the past year, but it still sports a P/E around 12 and a price-to-free cash flow ratio in the mid-teens. Those are fairly cheap multiples for a company that grows revenue 20% to 30% a quarter. It sports a lovely balance sheet containing $19 million of cash, no debt, and no significant amount of operating leases. Over the past few years, it has also lowered its cash conversion cycle from 104 days to 72 days, which improves its ability to use its cash.

The "Magic Formula" technique has worked well for Greenblatt, helping him to generate annualized returns of 40% over 20 years. And it could work well for you, either by itself or in combination with other analysis.

The Hidden Gems team uses screens to find undervalued small-cap stocks but also digs into qualitative measurements like management, products, customers, and strategy. From looking at their results, it seems to be working pretty well. If you're interested in learning more, you can join in the fun by taking a free 30-day trial.

So as of today, I'm off and running as a small-cap investor. Before you know it, I'll be "selling" put options. Hmm. Then again, maybe I should just plan to call my Mom each Sunday. After all, there's always 2007.

Andy Cross hopes to invest in a few small-cap stocks soon, but he probably should also finish War and Peace. This mama's boy is a co-host of The Motley Fool's new Podcast,Taking Stock. At the time of publication he owned shares of Merck, a Motley Fool Income Investor pick. The Fool has a disclosure policy.